Red Hat Stock: 3 Pros, 3 Cons

Red Hat has turned open source into big business, but competition is fierce and the stock is expensive

Red Hat Inc (RHT) is ending the year with a flourish, as the stock has hit a 52-week high of $70. This puts the market cap at nearly $13 billion. In the past year, RHT stock has gained about 23%.

red-hat-rht-stock-logo-185Much of the recent gain came after the company posted a strong third quarter on Dec. 18. Revenues came to $455.9 million, up by 15% on a year-over-year basis. The adjusted earnings were $79 million, or 42 cents per share. The Street was looking for revenues of $451 million and earnings or 40 cents per share. The stock opened 10% higher  the next day and then quickly hit a new high. It has been trading near $69 a share so far this week.

So is it still a good time to buy RHT stock? Or should investors wait? To see, let’s take a look at the pros and cons.

RHT Stock Pros

Powerful Business Model. The traditional software model involves a company that has a team of engineers that create applications. For this, it will either charge a license fee or a subscription.

But RHT has a much different approach: open source. This means that an application is part of a project that any coder can contribute to. For this, the software is free. Because of this, the technology often evolves and improves.

Then how does RHT make money? It charges fees for consulting, installation, integration, maintenance, support and training. As seen with $1.5-plus billion in annual revenues, open source proves that a “free” product can be quite valuable.

Mission Critical. RHT has a wide-array of offerings that provide help with key areas of the datacenter, such as operating systems, virtualization, middleware and storage.  Because of its depth, Red Hat has been seeing much more success with larger customers.

Just look at Q3. RHT renewed all of its 25 top deals, which grew an overall 120% in annualized sales. The top 30 deals all boasted revenue totals greater than $1 million and 12 were over $5 million. There were three transactions in excess of $10 million.

Financials. Red Hat’s numbers are rock solid. For the past 11 consecutive months, RHT has posted revenue growth in the mid-to-high teens. But the company has also continued to benefit from high margins. In Q3, cash flows jumped by 40%. In all, there is $1.65 billion in the bank. This means the company can continue to buy back shares or remain aggressive with its deal-making.

Red Hat’s core business is also light on capital expenditures. During the latest quarter, RHT spent only $12 million on property and equipment. The result was that free cash flows were a hefty $121 million, up 48% on a year-over-year basis.

RHT Stock Cons

Competition. While it is encouraging that RHT is winning bigger deals, it also means that the company must take on bigger rivals. Just some of its mega-competitors inclue Microsoft Corporation (MSFT), Oracle Corporation (ORCL), EMC Corporation (EMC) and VMware, Inc. (VMW). These companies have the advantages of long-term relationships with many global customers. But if Red Hat makes inroads, they also have the resources to fight back, such as with better technologies or even lower prices.

RHT must also compete with consulting and service providers, such as Accenture Plc (ACN). These companies have global platforms and teams of experts. That can be an edge when snagging big customers.

Macro Economics. While the US is growing at a nice pace, there appears to be choppiness across the globe. In Europe, the overall economy remains stagnant. There are also signs that China is decelerating as well as Latin America. In this environment, it could be tougher to close foreign sales.

Already RHT has felt headwinds. In Q3, revenues would have been $13 million higher if foreign exchange rates were the same as Q3 in 2013. And yes, the strength in the US dollar is likely to continue to cause problems, especially as it appears that interest rates will rise in 2015.

Valuation. RHT stock is far from cheap. Consider that the forward price-to-earnings ratio is at a 37. This compares to 15 for Microsoft, 14 for Oracle and 20 for VMware. The Wall Street consensus on the price target for RHT stock is about $73. This is only about 5% higher than the current price.

Verdict on RHT Stock

Open source has become a key part of the information technology infrastructure of many companies. These firms need the help of a veteran open source expert like RHT to make the technology work optimally.

Time and again, RHT has shown that it knows how to evolve its offerings. For example, the company recently purchased FeedHenry, which is a top player in the fast-growing mobile infrastructure market.

Despite all these positives, RHT stock is a risky bet. Given the large sizes of its contracts, there could easily be lumpiness in quarterly results, especially if there is slowing global growth. At the current valuation, any disappointment in results would lead to a steep sell-off.

Should you buy RHT stock? Not now — the valuation is just too high.

Tom Taulli runs the InvestorPlace blog IPO Playbook. He is also the author of High-Profit IPO StrategiesAll About Commodities and All About Short Selling. Follow him on Twitter at @ttaulli.  As of this writing, he did not hold a position in any of the aforementioned securities.

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